New Medium Risk Strategy being introduced to Allocations
After hearing about a new strategy opening by Osterweis, the Strategic Investment fund, the Global View Investment Committee set up a conference call with the portfolio managers. We were impressed with the risk/ return history of their equity and fixed income portfolios and in particular their attitude towards guarding against downside risk with a track record since 1983. We have used their Strategic Income strategy, which owns bonds, for a number of years. This strategy may own bonds of any credit quality and duration depending on the opportunity set. Most impressive, Carl Kaufman, who runs the bond strategy lost only 5% in 2008 when many corporate bond funds were down over 25%. Also very impressive, their equity strategy lost less than 30% in 2008, substantially helped by having not owned any banks. The new strategy gives the management team the flexibility to utilize both bonds and stocks. Assets are allocated based on the relative attractiveness of equities vs. fixed income according to the firm’s strategic outlook, which they publish quarterly. We back tested this strategy by allocating 50% to Strategic Income (Fixed Income Strategy) and 50% to Osterweis Fund (Equity Strategy) every year to see how this would have fared during the 2007-2009 downturn and discovered it would have looked very similar in risk and return to IVA Worldwide or FPA Crescent. Specifically, during a period when the S&P 500 fell 55% and took about 5 years to recover, this strategy as back tested would have lost only about 18% and recovered within two years.
On Friday, September 13, the investment committee of Global View Investment Advisors had a conference call with John Osterweis and Matt Berler at Osterweis Capital to discuss their Osterweis Strategic Investment strategy and learn how to use this with our clients. Osterweis capital was founded in 1983 by John Osterweis and manages $10.5 billion in assets. We have used their Strategic Income strategy for several years and recently became intrigued with their Strategic Investment strategy which intends to produce equity like returns with substantially lower risk in the tradition of FPA Crescent fund or IVA worldwide. The Strategic Investment strategy may own from 25-75% equity and hold the remainder in cash or fixed income. Asset allocation is dependent on the firm overall view of the relative attractiveness of stocks vs. bonds and the opportunity set of compelling investments.
The Portfolio Manager, Matthew, discussed in some detail how this strategy attempts to deliver high risk adjusted returns. First, they seek to buy the right securities, stocks and bonds, that they believe are undervalued. Second, they seek to find the right mix of stocks and bonds depending on the investment opportunity set. Osterweis has been in this business for over 30 years and has developed some expertise for understanding when it is better to own stocks versus bonds. Moreover, they have been writing a Strategic Investment Outlook for several years that we went back to read before the call. Of note, prior to the financial crisis, Osterweis did not own any bank stocks because they were worried about leverage from bank loan securitization and falling home prices and correctly identified that the US economy was in recession in Q1 of 2008.
We had the opportunity to ask John and Matthew a number of questions.
First, we asked them the give us their view on the US economy. According to them the US economy has recently been in a condition analogous to the 1930s due to the accumulation of debt and the credit bubble which burst in 2007, causing fear of a double dip recession. They wrote about this fear in 2011 but also suggested that the world central banks might embark on a coordinated policy response to mitigate its downside risk. We now know that the Long-Term Refinancing Operations of the European Central Bank and the subsequent quantitative easing program of the US Federal Reserve were that response. Osterweis now believes the US economy private sector has experienced 3-4% real GDP growth over the last 12-18 months during a period of fiscal consolidation where government spending has been reduced and that the economy has reached escape velocity. They believe growth will continue to be slow but that we will continue to experience a slow/steady expansion. Moreover they believe low interest rates will continue to be helpful to US consumers and allow them to grow spending 3-4% p.a. in real terms.
The next question we asked was about margin debt. Margin debt as a percentage of GDP has recently been at an all-time high, for some indicating speculation is out of bounds. John and Carl responded that on this metric as well as student loan debt, debt levels are out of bounds. However, they believe other credit metrics which represent a bigger piece of the pie such as installment, credit card debt and mortgage debt are in much better shape. Specifically, that the Fed’s actions to reduce interest rates has substantially reduced consumer’s interest rate burden and that now consumers are largely delevered. In conjunction, John believes US corporates are in “awfully good shape,” especially the banks. Metrics like debt/ equity are reasonable and companies have substantially reduced their interest rate coverage by reducing their cost of debt. He gave us the example of Johnson and Johnson (JNJ) as a company in very good shape. JNJ is an excellent company that has an excellent dividend and AAA rated credit. The company has raised its dividend over the last two years but its price has risen more than the rise in the dividend and bond prices have also risen to reflect the improved state of the company. Osterweis nonetheless believes that at this point in time you are better off owning shares of the equity than the bond. The dividend yields 2.6% and a 10 year bond could be expected to yield about 3.9% to maturity, however JNJ should grow its earnings. With $5.51 in earnings over the last 12 months and at a price of $105, JNJ does not look cheap, but its earnings to price (earnings yield) of 5.5% is compelling in relation to its bond yield.
In this new strategy Osterweis has the ability to own the debt or the equity of a company based on relative attractiveness. We believe this is an excellent strategy in our Medium Risk category and will be offering it to our investors.